Friday, November 16, 2012

Risk and Retirement Finances

In my last blog post, I described a recent article by Paula Hogan and Rick Miller about different approaches to financial planning. 

I'd to come back to an issue from that article related to risk management for retirement finances. They make a clear distinction between two risk concepts:

Risk tolerance: comfort in dealing with portfolio volatility (not being stressed out and losing sleep over the day's market events) and an ability to “stay the course” and not panic after a market drop.

Risk capacity: the ability to experience portfolio losses without suffering a major life setback or a major reduction to one's standard of living

These ideas also relate to other terms related to risk, such as the ability, willingness, and need to take risk. A variety of sources talk about this, and the source I have in front of me while writing this is Larry Swedroe's The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments (Bloomberg).

Ability to Take Risk: This is risk capacity. Larry Swedroe indicates that this relates to four factors: investment horizon, stability of earned income, need for liquidity, and alternative options available if things go bad.

Willingness to take risk: This is risk tolerance.

Need to Take Risk: This one can get a little confusing. Simply, the higher expected return one needs to meet their goals, the higher amount of risk is needed. One clear implication is that, as William Bernstein says, if you've already won the game then stop playing. That is, if you are at the point where you are satisfied with your lifestyle, then the possibility of increasing your lifestyle by another 50% is not worth the risk of being forced to reduce your lifestyle by 50%. At some point be satisfied with what you have and don't be greedy. 

The confusing part is when you haven't won the game. A strict interpretation is that you must increase your risk... make a Hail Mary pass in an attempt to achieve your financial goal. This would be more in line with probability-based approaches in which the probability of failure counts more than the magnitude of failure. 

But the safety-first approach would suggest that you revise your goals (save more, retire later, spend less in retirement) so that you do not need to take so much risk to achieve them. Even if you "need" more risk, you shouldn't take more risk than justified by your risk tolerance and risk capacity. In terms of risk capacity, it is not wise to put essential needs at risk.   

Applying Risk to Retirement

In applying these ideas to retirement, what becomes increasingly clear is that risk capacity starts to diminish rapidly. Having "pensionized" sources of guaranteed income help to increase the risk capacity, but as returning to work becomes less of an option, so does the ability to take risk. The investment horizon is shorter, the ability to generate new income sources reduces, more liquidity may be needed for health expenses, and alternative options to reduce expenses or change lifestyle may decline with increasing age.

As risk capacity reduces, risk tolerance can really come to smack a retiree in the face. What risk tolerance really comes to mean for a retiree is understanding how well one can deal with the prospect of reducing their lifestyle. Being more aggressive in this case means understanding and accepting that lifestyle may have to be reduced if things don't go well. Aggressiveness can be manifested both by spending at a higher rate (in order to enjoy early retirement more) and by using a more aggressive asset allocation (to obtain more upside potential). Having larger amounts of guaranteed income sources to fall back on also supports greater risk tolerance. 

For those with greater risk tolerance, spending well above the "safe withdrawal rate" could be perfectly acceptable. For those with less risk tolerance, spending conservatively, investing more conservatively (without overdoing it), and considering partial annuitization into guaranteed income sources are all alternatives.